By Griffin W. Huschke, Mayme and Herb Frank Research Fellow
Today the New York Times carried a piece discussing Germany’s new assertiveness in the eurozone as it attempts to establish new rules for the economic union. Deutschland is tired of paying off the creditors of profligate countries, and wants the EU to pass a boatload of rules and regulations to whip the economic union into shape by, among other things, forcing debtor countries to commit to austerity measures when their debt levels get to high. Turns out that when you ask for a loan after cooking the books for decades, or letting your banks take unsustainable amounts of risk, German taxpayers, a.k.a. your creditors, want to make sure you don’t keep stuffing money down ratholes.
We’ve hinted that the euro is going to have to work through some significant growing pains in the next couple of years as the common currency rebounds from the worst recession in its history. As economist/rock star/historian/political theorist/xeno-paleontologist Niall Furguson said at a recent World Bank conference, financial markets and regulations are constantly evolving, and occasionally you need an “economic asteroid”, or a large recession, to wipe out the inefficient market systems and regulations. As Europe plays Morgan Freeman to the Deep Impact of the financial crisis, the eurozone’s toughest challenge may be figuring out who pays when member states get in over their heads with debt.
The thing is, we already know who’s going to pay, but its just going to take a lot of wrangling and soul searching in Brussels, Berlin, Paris, and elsewhere to come to the same conclusion economists came to a couple hundred years ago. See, the EU works a lot like the US financial systems—there are states with a common currency and each state can borrow on its own terms. But unlike the EU, when a US state gets in over its head, a la California, the Feds bail out the state until it can get its affairs in order. It happens all the time, and no one really thinks too much about it.
As of right now, the eurozone doesn’t have that kind of capability, leaving a financial system in place that’s the equivalent of California begging surplus funds from Virginia. In this system, Virginia could say no, which creates fluctuation in financial markets, and is bad for governments who need stable finances. In the end, Virginia and California both lose because their balance sheets aren’t guaranteed by massively stable, overarching financial system like the Federal government, which is a lot like the eurozone system today. As European leaders continue to work out their new economic measures, they’ll have to figure out how to make their financial integration look more like the U.S.
The EU has some work ahead of it to successfully hammer out a compromise that accommodates all parties, including debtors and creditors, in a guaranteed debt mechanism. The Founding Fathers had to agree to move the Capitol from cushy Philadelphia to a disease infested swamp known only for “producing nothing except myriads of toads and frogs (of enormous size)” as part of a hard-fought compromise that created such a debt mechanism. The EU may have to go through some similar trials (Scotland has expansive lowlands) and there are a number of other pressing issues that the EU will have to deal with before the euro operates in a way that doesn’t freak out Paul Krugman. But, much like the President in Deep Impact, they’ll keep working to rebuilding their asteroid-ruined financial systems better than ever.